Iceland abandoned

Last year, Iceland was considered an economic success story; it was one of the world's 10 richest and freest countries enjoying a strong pension system, strong economic growth and one of the lowest poverty levels in Europe. However, all went wrong in October of 2008: the 3 main Icelandic banks collapsed and the local currency, the krona, went into free fall.

Why did the international financial crisis hit Iceland so hard? A plausible answer is that Iceland's banks were oversized: with assets worth more than 10 times the country's gross domestic product (GDP), the Icelandic Central Bank simply could not act as their only lender of last resort, says Hannes Gissurarson, board member of Iceland's central bank and professor of political philosophy at the University of Iceland.

Yet, while so many Icelandic bankers may have behaved recklessly, there is another side to the story:

In 1994, Iceland joined the European Economic Area (EEA) – a free-trade zone uniting the 27 European Union (EU) member states with Norway, Liechtenstein and Iceland – with the idea that any company based within the EEA could operate freely throughout the area, provided it followed the rules.

The Icelandic banks took this seriously and began operations in other European countries; efficient, aggressive and technologically advanced, they often offered better terms than their competitors.

By 2007, the banks were quite solvent, but there was a foreseeable liquidity problem; when the Icelandic Central Bank tried to obtain credit lines from other EEA banks, it was refused almost everywhere.

A couple of the banks might have survived if the government had not used the country's anti-terrorist law to take over their assets and operations, and the bank even found itself listed briefly on the British Treasury's list of terrorist organisations.

These British measures significantly worsened Iceland's financial crisis. The island's banking system and foreign trade collapsed. Unsurprisingly, banks are reluctant to transfer money to and from "terrorists," says Gissurarson.

Furthermore, the central banks in the EEA that refused to come to the assistance of the Icelandic Central Bank and the Iceland government probably did not anticipate the damage their inaction would cause even beyond Iceland's shores, says Gissurarason.

Source: Hannes H. Gissurarson, Iceland Abandoned, Wall Street Journal, November 17, 2008.

For text: http://online.wsj.com/article/SB122695569056034695.html

For more on International Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=26

FMF Policy Bulletin/ 25 November 2008